“Fed Raises Interest Rates for Third Time Since Financial Crisis”
Now we can bring everything together. How the Fed, the banks, the dealers, interest rates and assets prices are all linked together and what happens in a crisis. The central bank is supposed to keep the balance of elasticity and discipline in the monetary system and to control the flow of credit and to provide internal stability.
The Treynor Model
The Fed funds rate influences the (Repo/)Term rate, which influences the asset prices. I will explain every model and then linked them to each other.
The first model shows the Fed Funds rate (the rate at which banks are lending money to each other). The higher the settlement risk, the higher is the Fed Funds rate. The settlement risk of needing to make a payment, but all your money is locked up in long-term loans. The settlement risk comes from borrowing short and lending long. (Banks: have short-term deposit accounts, but borrow long term e.g. loans for mortgages)
The Fed puts a “floor” under that rate at 100 basis points. That is the "IOER" = interest on excess reserve. (Since March 2017 the IOER is 1% = 100 basis point). Which means that a bank can always leave its money at the FED and get 100 bp for it. This is the safest place to leave their money (= surpluses/ excess reserves). Hence, the lowest rate a bank will borrow money to another bank is above the 100 basis points, because there is a risk involved. Therefore the first option for a bank is to leave it for 100 bp at the FED. The second option for a surplus bank is to lend their money in the Fed Funds market to another bank and earn more than 100bp, but they have to carry the risk.
The Fed can control the settlement by regulating the money supply. The central bank can either print notes (more money) or buy notes (less money).
How can the Fed do that:
Markets are not doing good -> fewer loans -> more discipline -> tighter financial condition
Solution: More money in the market
Therefore the Fed prints money -> buys treasury bills from dealers, banks and maybe private persons -> now they have notes and want to spend them -> elasticity (more money supply) -> lower Fed Funds rate > more credit = economy boost
Imagine: The Fed buys treasury bills from me. Now I have money and can spend more money for my party. Hence I put money from the Fed into the economy. The Fed can also do the opposite and sell treasury bills to get notes out of the system, so the settlement risk becomes greater which drives up the Fed Funds rate.
Then we have the liquidity risk in the next model. The higher the liquidity risk the higher the term rates. Normally term (=repo) rates are cheaper, than the Fed funds rate, because the market and the competition are way bigger, due to the fact that only members of the Fed can participate in the Fed Funds market. Whereas almost every financial institution can participate in the Repo Market. The problem is, if markets are panicking, no one trusts each other anymore, so they will give away less and less credit and there won't be enough liquidity. Consequently, the term rates will be higher.
How are they linked together?
Now I explain how the are all linked together and I will use a crisis to emphasize the mechanism.
In a crisis, we have more discipline, because people are not taking out credits and banks are getting afraid of giving out loans, due to a higher default risk. The banks are trying to keep their money together and that drives up the Fed Funds rate.
Accordingly, banks do not really lend to each other anymore so they are starting to borrow more within the term/repo market. That drives up the term/repo rates because there is more demand and the liquidity risk is greater as well.
Hence, getting money becomes more and more difficult, which means banks and dealer are starting to sell assets and don’t buy new ones.
Consequently, the prices of assets are depreciating (falling).
So if the Fed jumps in and says that she is willing to help out, banks and dealers are distressed and giving out loans at better rates and are able to trust each other again. The market is relieved. Unfortunately, it is not as easy as the model, but this is the main mechanism behind the banking system.
In times of zero interest rates and way too many notes in the market, the Fed has limited power to jumpstart an economy. The only thing it can pretty much always do is to slow down an economy by raising the interest rates. Which also raises the Fed Funds rate.
Higher rates = less credit = less growth
Financial Times Quote: If you visit the Website of the Fed, you can see the current IOER and that they raised it in March. So it is an important and interesting that topic is right now and now YOU know what happens when Janet Yellen raises the interest rates.
I know that these topics are quite complex so if you don't understand this article you are welcome to ask some questions or go back to the earlier articles.
The first article: The hierarchy of money
The second article: Why do we need banks?
The third article: Why we need a central bank?
The fourth article: How can banks create money out of thin air?
The fifth article: Why do we need central banks especially in a crisis?
The sixth article: What are clearing houses?
The seventh article: What are Fed Funds?
The eighth article: What are dealers, brokers and repos?
The ninth article: Quantitative easing and open market operation
The tenth article: Eurodollars
The eleventh article: Discounts, Discounts, Discounts
The twelfth article: Why dealers provide liquidity
Written by: Philine Paschen